Part Two:

Cost accumulation for inventory valuation and profit

measurement

Chapter Three:
Cost assignment

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3.1a

Assignment of direct and indirect costs

• Direct costs can be specifically and exclusively identified with a given cost
object – hence they can be accurately traced to cost objects.

• Indirect costs cannot be directly traced to a cost object – therefore

assigned to cost objects using cost allocations.

• Cost allocations = process of assigning costs to cost objects that involve

the use of surrogate rather than direct measures.

• Surrogates known as allocation bases or cost drivers.

• For accurate cost assignment, allocation bases should be significant

determinants of the costs (i.e. cause-and-effect allocations).
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3.1b

Assignment of direct and indirect costs

• Allocation bases that are not significant determinants of the costs are
called arbitrary allocations (.result in inaccurate cost assignment).

• Tradditional costing systems use arbitrary allocations to a significant extent

whereas more recent (ABC)systems rely mainly on cause-and-effect
allocations (see Figure 3.1 on slide 3.3a).

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3.2a

Different costs for different purposes

• Manufacturing organizations assign costs to products for:

1. Inventory valuation and profit measurement.

2. Providing information for decision-making.

• For inventory valuation and profit measurement the aim is to allocate

costs between cost of goods sold (COGS)and inventories:

1. Accurate individual product costs are not required – only an accurate

allocation at the aggregate level between inventories and COGS.

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3.2b

Different costs for different purposes

• For decision-making more accurate product costs are required.

• Different cost information is required for inventory valuation and decision-

making but most companies use a single database and extract different
costs for different purposes.

• Companies can choose to maintain their database using costing systems

that vary on a continuum from simplistic to sophisticated (the choice should
be based on costs versus benefits criteria – See Figure 3.2 on slide 3.3a).

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3.3a

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3.3b

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3.4a

Assigning indirect costs using blanket overhead rates

• Some firms use a single overhead rate (i.e.blanket or plant-wide) for the
organization as a whole.

Example
Total overheads = £900 000
Direct labour (or machine hours) = 60 000
Overhead rate = £15 per hour

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3.4b

• Assume that the company has 3 separate departments and costs and hours are
analysed as follows:

• Product Z requires 20 hours (all in department C)

Separate departmental rates should be used since product Z only consumes

overheads in department C.
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3.4c

• A blanket overhead rate can only be justified if all products consume

departmental overheads in approximately the same proportions:

Product X spends 1 hour in each department and product Y spends 5 hours

in each department (Both blanket and departmental rates would allocate
£45 to X and £225 to Y).

• If a diverse range of products are produced consuming departmental

resources in different proportions separate departmental (or cost
centre)rates should be established.

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3.5

Cost centre overhead rates

• Where a department contains a number of different centres (each with

significant overhead costs)and products consume overhead costs for each
centre in different proportions,separate overhead rates should also be
established for each centre within a department.

• The terms cost centres or cost pools are used to describe allocation to
which overhead costs are initially assigned.

• Frequently cost centres/cost pools will consist of departments but they

can also consist of smaller segments within departments.

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3.6a

The two-stage allocation process

• To establish departmental or cost centre overhead rates a

two-stage allocation procedure is required:

Stage 1 – Assign overheads initially to cost centres.

Stage 2 – Allocate cost centre overheads to cost objects
(e.g.products)using second stage allocation bases/cost drivers.

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3.6b

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3.7a

An illustration of the two-stage process for a traditional costing system

• Applying the two-stage allocation process requires the following 4 steps:

1. Assigning all manufacturing overheads to production and service cost

centres.
2. Reallocating the costs assigned to service cost centres to production
cost centres.
3. Computing separate overhead rates for each production cost centre.
4. Assigning cost centre overheads to products or other chosen cost
objects.

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3.7b

• Steps 1 and 2 comprise stage one and steps 3 and 4 relate to the
second stage of the two-stage allocation process.

• Note that in the third stage above traditional costing systems mostly use
either direct labour hours or machine hours as the allocation bases.

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3.8a

The annual overhead costs for a company which has three production
centres and two service centres (Materials procurement and General
factory support) are as follows:

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3.8b
The following information is also available

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3.9a

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3.9b

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3.10

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3.11

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3.12

(continued)

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3.13

Budgeted overhead rates

• Actual overhead rates are not used because of:

1.Delay in product costs if actual annual rates are used.
2.Fluctuating overhead rates that will occur if actual monthly rates are used.

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3.13

Budgeted overhead rates

• An estimated normal product cost based on average long-run activity is

required rather than an actual product cost (which is affected by month-to-
month fluctuations in activity).

• - therefore use estimates of overhead costs and activity over a long-

run period (typically one year)to compute overhead rates
(i.e.£10 per hour in the above example).

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3.14

• Assume actual activity is 900 000 DLH ’s and actual overheads are £2 million:

Overhead allocated to products = £1.8 million

(900 000 × £2)
Under-recovery = £200 000

• Assume actual overheads are £1 950 000 and actual activity is 1 million DLH ’s:

Overhead allocated to products = £2 million

(1 million ×£2)
Over-recovery = £50 000

• External financial accounting principles (GAAP) require that under/over

recoveries are treated as period costs.

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3.15

Non-manufacturing overheads
• Financial accounting regulations specify that only manufacturing
overheads should be allocated to products.
• Non-manufacturing costs should be assigned to products for decision-making
(Particularly cost-plus pricing).
• Simplistic methods, such as using direct labour hours, or a percentage of total
manufacturing cost, are frequently used as allocation bases with traditional
systems.

Example
Manufacturing cost = £1 million
Non-manufacturing overheads = £500 000
Overhead rate = 50%of manufacturing cost

• Simplistic methods do not provide a reliable measure of the

non-manufacturing overheads consumed by products.
• ABC is advocated for providing a more accurate measure of
resources consumed by products.
Use with Management and Cost Accounting 8e by Colin Drury
ISBN 9781408041802
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